I read an interesting article from Allan Roth. It addresses some recent discussion on bond funds and dividend stocks taking the place of bond funds. I am conservative and agree with his analysis. You may not.

I read an interesting article from Allan Roth. It addresses some recent discussion on bond funds and dividend stocks taking the place of bond funds. I am conservative and agree with his analysis. You may not.

Couldn't agree more. I cringe a little at all the talk of principal preservation (AKA not having to sell shares) and the safety of large-cap dividend stocks or funds. It blows my mind that seemingly intelligent investors really do not understand that a dividend is not free money; And that it is actually better tax-wise in nearly all cases to sell some shares and pay LTG, as opposed to having a high dividend-yield which you live off of.

Oh well. If it helps them sleep at night and not sell their shares in a bear-market/crash, then maybe it is for the best.

Thanks for the link. Allan covers a lot of different fixed income issues.

Let’s say intermediate-term rates rose two percentage points in one year. In that case, an investment in BND would lose nearly 10% of its value. But the Sallie Mae 5-year direct CD, currently yielding the same 2.35% as BND, would instead return 1.17% after paying the early-withdrawal penalty, while freeing up cash to reinvest at higher rates. In short, this strategy gives clients intermediate-term yields with only ultra-short-term interest rate risk.

I always like to remind people that the losses on any bond funds held in taxable accounts, munis, etc., would be mitigated by tax loss harvesting. One should take this into account when thinking ahead about bond and fixed-income investing, and what might happen during a period where interest rates rise. For those in the highest brackets that 10% loss in BND might only really cost 5%.

The third way to safely amp up clients’ returns is to tell them to pay down their mortgage. Though I often get hate mail from advisors when I write about this, the math is compelling and simple. The mortgage is merely the inverse of a bond, and your client is not going to make money borrowing at 4% only to lend it out at 2.8% or less.

I don't necessarily disagree on this, but I have conservative clients who won't get more aggressive than 50/50 stock/bond despite being in their 30s/40s and in the accumulation phase, and who also want to direct every extra dollar to a 3.25% mortgage. Everyone must "sleep at night" but liquidity has some value. Also, if one wants to consider a mortgage a negative bond, then one who plans to consistently direct extra money to the mortgage should in theory consider holding more equities than otherwise.

STK

-- Real name: Sotirios Keros. If you have to ask "Is a Target Retirement fund right for me?", the answer is yes.

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Couldn't agree more. I cringe a little at all the talk of principal preservation (AKA not having to sell shares) and the safety of large-cap dividend stocks or funds. It blows my mind that seemingly intelligent investors really do not understand that a dividend is not free money; And that it is actually better tax-wise in nearly all cases to sell some shares and pay LTG, as opposed to having a high dividend-yield which you live off of.

Agreed, and that's part and parcel of the misunderstanding. Principal is money somebody legally owes somebody else. Stocks do not have principal. Nobody owes nobody nuttin'.

Bonds have principal. CDs have principal. The mortgage you owe has principal. Somebody owes somebody sumttin'.

People don't take into account that while the dollar value of a bond fund goes down in a rising rate environment, as bonds are sold and new ones bought by the fund, the newer bonds have a higher yield. Eventually the higher yield makes up for the initial loss in value. The amount of time it takes is roughly equal to the average bond duration of the fund. So if you hold a bond fund with an average duration of 5 years, you will make up any losses in 5 years, and then continue to benefit from the higher yield thereafter. For a long term investor with 10, 20, 30+ year horizon, rising yields are a good thing.

People don't take into account that while the dollar value of a bond fund goes down in a rising rate environment, as bonds are sold and new ones bought by the fund, the newer bonds have a higher yield. Eventually the higher yield makes up for the initial loss in value. The amount of time it takes is roughly equal to the average bond duration of the fund. So if you hold a bond fund with an average duration of 5 years, you will make up any losses in 5 years, and then continue to benefit from the higher yield thereafter. For a long term investor with 10, 20, 30+ year horizon, rising yields are a good thing.

I'm afraid the underlined part is a misunderstanding. Yield, which by convention if the speaker doesn't specify otherwise means Yield to Maturity, YTM, immediately rises because it's calculated against present market price.

You may be referring to coupon payments, which remain level for the life of uncomplicated bonds, but those aren't yield. Payouts are important, but they are only one component of yield. Please see the link for details.

I'm not picking on you personally, czeckers. Lots of people think that.

You are of course correct. In the future I'll choose my words more carefully. Having said that, I still stand behind my primary point which is that rising interest rates benefit long-term bond investors.

There are investors in higher marginal tax brackets who may be heavily invested in municipal bond funds. We're lucky that Vanguard offers both intermediate-term and long-term California funds; I've only used the former. However, many residents of various other states have access to only long-term state-specific tax-exempt bond funds. Those funds have durations of 15-17 years. If interest rates were to tick up 2 percentage points, you'd expect to see the NAV fall by about 30%. Or, point another way, you'd need to wait 30 years to recover those losses, which is an awfully long time to wait. Of course, these calculations are very, very rough estimates but I think it would be fair to say that one would have to be very patient.

However, many residents of various other states have access to only long-term state-specific tax-exempt bond funds. Those funds have durations of 15-17 years. If interest rates were to tick up 2 percentage points, you'd expect to see the NAV fall by about 30%. Or, point another way, you'd need to wait 30 years to recover those losses, which is an awfully long time to wait.

Huh? If the loss is defined in total return relative to a projection before the step "tick up", then the time to recover is just the ex ante duration. If you are implying that a convexity effect would account for the difference in years for a 2% tick-up, then show me.

You know, you're right. I actually fell for something that I usually recommend against. The traditional way that investment books describe duration is a measure of volatility: the longer the duration, the more the volatility. And in general, most would further explain that for 1% rate increase, you can expect the principal to fall by the calculated duration. Where things, at least to me, become harder to get behind is the "point of indifference" which is often used to describe duration; the calculated duration is the point when the investor "breaks even."

In reality, your point is more applicable. You're going to be reinvesting the dividends (hopefully). If you take a look at several points in time when interest rates have increased, you're going to have very different results:

So I apoligize for the inordinate drama which I espoused with long-term bonds and interest rate risks. I still find it difficult to imagine that long-term bond fund holders will have an easy time in an increasing rate environment, and the majority of retirees who are holding long-term bond funds will not be reinvesting those dividends. However, I am reminded that the Trinity study actually uses long-term corporate bond returns in its calculations. Nonetheless, I continue to believe that, as a rule, most investors would be better off investing in bond funds with durations that would match their needs for the money.

You are of course correct. In the future I'll choose my words more carefully. Having said that, I still stand behind my primary point which is that rising interest rates benefit long-term bond investors.

Completely agree with you here. The point is that coupons from existing holdings are being used to purchase new bonds with a higher coupons to match the current market rate. I also misuse the term 'yield' as did you quite often. In my mind the newer bonds are 'higher yield' than the bonds I have...when in reality they are the same yield, but only because the value of my bonds have dropped to compensate for the higher market rate coupons. It is really semantics in my mind and your point is not lost.

I, myself, look forward to higher interest rates. I am tired of the risk-free rate being around 1%.

I am not an investment professional, but I did stay at a Holiday Inn Express last night.